Monday, January 19, 2015

The talk over the past couple of years has been, when does the Fed raise its discount rate? The fact of the matter is this talk is to be taken with a grain of salt, as any possible threat is met with assurances from some Fed dove that raising rates in the near term just isn't possible. I have a few explanations to offer that go outside of this jawboning policy, that actually moves to the point that only the market will ever raise rates, as the Fed is stuck on zero.

The first point to make is that since the Japanese bank went to zero, a bank that actually went so far, has never been able to get out of the trap they built themselves. There are many reasons why this is the case, but the primary one is that the monetary base has no natural way to have increased itself while stuck at zero. A zero fed funds rate raises no money for depositors or bankers, who have excess cash. The only thing that grows is the monetary debt associated with increased bank lending in the first place. Thus, debt has either increased or remained flat, while the compound interest equation has consumed the means of repayment. For those that don't understand this policy, I will go into details.

All the money in circulation today has been created by the system of banks either creating debt or buying the debt of others. This includes the central banks, which must maintain a balance sheet that at least presents a case of solvency. In making such loans, they never create the interest with which to pay the debt back to its source. Repayment has to either come out of the deposit balances in the banking system, out of the capital position of banks or out of the forfeiture of property, in the event of default. In any case, the ability to service debt, placed on the debit side of the bank ledger, has to come from the credit side of the ledger. This is what constitutes the entire base of funds to service the cumulative ledgers of the banking system.

Once we have met zero, all kinds of carry trade financing takes place. Banks and other entities that have the capacity, borrow at zero and buy higher yielding securities that give them a free ride, along with allowing all sorts of borrowers a source of lower financing, much lower than the normal risk situation presented often deserves. To raise rates, puts this entire systematically created situation at risk. The carry trade in various currencies around the world is in full force and effect.

How large is this trade? I have no way of knowing, but I would suspect it is behind the low government rates around the world, just as is QE itself. As more money is put on the debit side of the bank ledger, more funds become available at zero, to anyone willing to take the risk. The Japanese carry trade has been happening for close to 20 years. Japan has never moved off the zero rate. The 10 JGB is trading about as close to zero as could ever be imagined for a government that for all practical purposes is insolvent and has absolutely no mathematical capacity to service its debt any anything resembling a real interest rate. Its entire tax revenue would be consumed at such a rate.

As long as those in position to know can make the assumption that rates are going to remain at or almost at zero, this trade will go on. It appears to me they have the central bankers trapped, as the losses of even a couple a percent move in longer dated paper would create a margin call that exceeds the capital of the entire system that supports such carry. A 20% haircut on sovereign debt or corporate debt issued to support the trillions in stock buybacks and acquisitions would make the subprime disaster look like a rained out picnic.

Then, one must look at the other side of the game, the banking system itself. Excess reserves total in the multi-trillions in the US alone. How could such a massive pool of money be put in demand to create a bid, when the system is so flush with cash? Are the central banks going to commit suicide and destroy the mark to market on what they hold as collateral, in order to raise rates? To reverse QE and start selling bonds would by itself, destroy the leveraged carry trade. I suspect this activity isn't even in the cards.

The proposed method is to raise the interest rate paid on reserves. That rate, from what I understand, is at 1/2%. There is no real bid in the Federal funds market or the rate on funds would be what the Fed would pay on reserves, in the first place. Why would it be any less? Why would banks give up this rate to lend these risk free funds in the broad market? Is it because no one needs any funds at this level of supply or am I missing something? It would only be the Fed itself providing funds at a lower rate that could answer any needs of funds. Absent a bid, there is no Fed funds market.

My preferred means of raising the discount would be to raise the reserve requirement. This would fly in the face of the TBTF banks, as they would be the most likely entities that would be affected by such a move, in that they would be most likely the more highly levered institutions. Could we see such a move? I highly doubt it.

Without a system that needs funds, how can the Fed create a bid? They are limited as to how much they can pay on reserves, because they are the holders of such a large amount of low yielding paper. I would suspect, having some clue as to the rates of interest on 10 year paper over the past few years, they would be limited to maybe 2.5% to 3% on the top. This is hardly a real interest rate, but high enough to upset the finances of government and destroy any carry trade in dollars. A 2% inflation rate, from what I have been taught, implies a 5% risk free rate on bonds. A move in the coupon from around 2% to 5% on a 10 year bond, implies a roughly 25% loss in current market value of such securities. How could such a move be transacted for long?

In this vein, we are faced with only 3 remedies for the Fed to raise rates. Sell assets and draw in money, raise the rate paid on reserves or raise the reserve requirement, forcing banks to hold more cash. The only one that can be successfully used over the short term would be to pay a higher rate of interest on excess reserves. But, this is limited to the average rate the Fed receives on its assets, surely less than 3%, which is a normal rate at around zero inflation. Pulling money out of the system, though the wise position, would create an unwind of the carry trade on bonds and the inflated stock bubble, destroying the false prices of assets we see at this time.

When a small group can purchase a return for free, we end up with an unbalanced economy and one that is rife with systematic risk. The average American doesn't have access to free money. Only those positioned to take advantage of the financial engineering mechanisms developed over the past 30 years have this advantage. In the meantime, it is mandatory that someone hold the excess money produced, whether it be the banks, which have the money immediately returned to them through the closed system of banking or the poor guy who saved his money and has sense enough to not trust the asset inflation that has come around to bite them over and over again.

In the end, at zero or at a higher rate, this system will collapse. It will collapse, because no one lives off their own body and the fact of the matter is the earnings excess we see in corporate America is a result of excessive debt, taken on largely by people that have no capacity to borrow and service more debt. Financing available to them is only available at rates a long way from zero, some of the subprime, paying rates that were against the law at one time. Paying zero on liabilities created by the entities that have been entitled to pay zero is also against the law, the law of nature and mathematics. Something that can't go on forever won't.